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April 3, 2013

When Clients Outlive Their Longevity Insurance: QLACs

The IRS has recently blessed the path to using qualified pre-tax dollars to purchase longevity annuity contracts.

While purchasing a qualified longevity annuity contract (QLAC) with qualified plan dollars can often raise questions of suitability, QLACs can guarantee that retired clients’ nest eggs remain fully funded no matter how long they live. With the possibility of escaping IRS RMD requirements added to the mix, QLACs present an option that might seem too good to be true. Unfortunately, the flip side of the QLAC strategy is simply that the client will not live long enough to reap the benefits of this longevity protection—exactly the risk that recent proposals seek to protect against.

QLAC Basics

A QLAC is essentially a type of deferred annuity product that the client usually purchases just before retirement, but for which payouts are delayed until the client reaches old age—typically payouts begin around age eighty or eighty-five.

One of the primary benefits of a QLAC is that the IRS allows the value of the QLAC to be excluded when the client is calculating the required minimum distributions (RMDs). Because including the value of a QLAC in determining RMDs could result in the client being forced to begin annuity payouts earlier than anticipated if the value of other retirement accounts has been depleted, the IRS determined that excluding the value from the RMD calculation furthers the purpose of providing taxpayers with predictable retirement income late in life.

The amount that a client can invest in a QLAC and exclude from the RMD calculation is limited, however, to the lesser of $100,000 (as adjusted for inflation beginning in 2014) or 25% of the client’s retirement account assets. The client must also begin annuity payouts no later than age 85, furthering the purpose of the QLAC as a type of longevity insurance that kicks in when the client may have begun to exhaust funds in other retirement accounts.

Cost of a QLAC

In order to make QLACs more affordable and easy to understand, the proposed Treasury regulations strictly limit the types of annuity contracts that can be considered QLACs (and thus can be excluded from the client’s RMD calculation). The stated intent behind the Treasury’s proposed regulations is to provide taxpayers with a predictable income stream late in retirement, not to provide the annuity bells and whistles that many contracts contain today.

Excluding these types of products is likely to simplify the market for QLACs, and it is also likely to make the products more affordable. Because there are no surrender benefits available to owners of QLACs, the initial premium invested is certain to grow for the entire deferral period, lowering the cost of coverage for companies offering these products by reducing the risk that the owner will surrender the contract.

The flip side is that eliminating the possibility of surrender increases the risk that your clients will never realize the value of their investments because they simply will not live long enough to begin the annuity payouts. Observers have recognized this problem, however, and have requested that the Treasury Department take steps to allow all or a portion of the initial premium to be refunded if the annuity owner does not live long enough to begin annuity payouts.

Conclusion

Whether the Treasury Department will allow a portion of QLAC premiums to be refunded if your client does not live long enough to require longevity insurance remains to be seen. Regardless, for some clients, the peace of mind that comes with knowing their retirement will be funded late in life may be worth the risk.

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